Dennis' Mortgage Blog

Question of the week:  You have mentioned it in previous updates, and I saw some headline or heard mention on the news, what does it mean that the Federal Reserve is not buying mortgages any more?

Answer:   I’ll cover this in three parts:  a review of how mortgage markets work and how the Federal Reserve (Fed) can buy mortgages, a review of their mortgage purchase program and a look at what is next for the Fed and mortgage markets. 

Mortgage Market Review

Fannie Mae and Freddie Mac are not lenders.  They are secondary market facilitators.  To be able to lend several billion dollars in 30 year mortgages banks have to have a continuous source of money to ensure the ability to continue to fund new mortgages before the old ones pay off.  To do this they bundle together tens of millions of dollars of mortgages into a package and sell the package to Fannie Mae or Freddie Mac depending on the underwriting criteria used to approve and fund the mortgages.  Fannie or Freddie purchases the package based upon an agreed upon price based on the average mortgage rate of the entire package (this is where your 30 or 60 day rate locks come in).  The bank gets cash back in its system to make more loans, Fannie and Freddie now have a bundle of mortgages and need cash.  They now take that bundle and combine it with bundles from other banks and sell interests in the mortgages in what are known as Mortgage Backed Securities, or MBS.

Mortgage Backed Securities are sold on the open market and many mutual funds participate in purchasing MBS for their bond funds.  The interest paid on the mortgage is paid to the bond holder and when a mortgage pays off the principle balance is paid to the investor—with slices along the way of course to the lender for servicing the loan, Fannie Mae for processing, bond fund manager, etc.  Once held the MBS can also be re-sold, also on the open market---keep this in mind for part three of this message.

When the MBS are put on the market they are like any other issuance in the investment markets. If there are a lot of buyers then prices are bid up, if there are few buyers prices drop to attract buyers.  As long time readers of my weekly updates are aware, for Mortgage Backed Securities, and bonds in general, higher prices at market mean lower interest rates, lower prices mean higher interest rates.   To make this easier to understand, imagine you and I are talking about your lending my cousin $15,000, you have the money but are worried about the risk and what else you can do with the money.  We start at 5%, not enough, 7%, not enough, finally 12% you say, that is enough and loan the money.  The same thing happens with MBS, except the interest rate is fixed so the price drops on the sale until someone agrees to purchase it.  Higher price means lower interest rate, lower price means higher interest rate—think of a teeter-totter.

Federal Reserve Mortgage Purchase Program

In January 2009 the Federal Reserve began a $1.25 Trillion program to purchase Mortgage Backed Securities for the next 15 months.  The purpose of the program was to provide liquidity to the mortgage markets and because there was so much money involved keep the prices of MBS bid up, and therefore interest rates low.  And it worked.  As you can see by the chart below rate in the second half of 2008 were above 5.75%.  In December when the news firmed up of the Fed purchase program rates dropped dramatically, finally settling around the 4.75% level.  A drop of 1% in the mortgage rate markets upon entry of the Federal Reserve into the MBS market.

The program was for a total of $1.25 Trillion in mortgages to be purchased starting January 2009 and ending March 31, 2010, this past Wednesday.  Divide $1.25 Trillion by 15 months and you get an average of $83.33 billion per month that the Fed was buying.  To give you an idea of how much of the market was the Fed, in January and February 2010 Fannie Mae sold about $88 billion in mortgages on the market.  Add in the volume of Freddie Mac and Ginnie Mae (federally insured mortgages, FHA and VA) and you can see that the Fed was basically the market on the buyers side.

Yesterday, April 1^st the Fed was out of the market.  The Mortgage Backed Securities being sold had to find traditional investors, and the prices needed to drop to be affordable, and drop they did.  At open the Fannie Mae 30 year mortgage dropped to its lowest level since January, today on Day 2 of no-Fed trading the market is down even further.

With the Federal Reserve in the market the government created an artificially inflated price for MBS, or if you prefer an artificially deflated rate of interest for mortgages.  With that artificial pricing element absent from the market prices will, and are, rising to meet the demand that is available.

But there is more to come.

The Fed’s Next Move and Impact On Mortgage Rates

Now the Federal Reserve, our nation’s central bank, holds $1.25 Trillion in residential mortgages.  In an economy that is still showing an increase in foreclosures in many areas, if not most. In an economy where rates are headed up and millions of homeowners have Hybrid ARMs that are at very low rates but will be headed up, leading most probably to increased foreclosures. In an economy with an unemployment rate of 9.7% and 11.3 million Americans receiving unemployment benefits.  In an economy where the Federal government has a current deficit of $1.4 Trillion and a budget proposal to double that deficit.

I am of the belief that the mortgages funded over the past 18-24 months represent the strongest credit risks of mortgages funded for any period over the past decade or more because of the tighter underwriting standards.  All the mortgages have verified income, with the exception some FHA streamline refinances.  The average credit score for borrowers in the past two years is considerably higher than the prior decade.  The average debt-to-income ratios are much lower on the current crop of mortgages, especially when “true” income is considered and not stated income.

Despite the strength of the mortgages as a whole, there is underlying weakness because of the overall economy and regional housing markets.  And the Federal Reserve currently owns $1.25 Trillion in residential mortgages.

But not for long.  As the Fed’s mortgage purchase program was coming to a close word has come out that the Fed in intent on dumping, or rather selling, its mortgage portfolio.  So not only will the MBS markets be contending with a demand vacuum created by the Fed’s sudden, albeit known, departure from the market, they will also be contending with an oversupply of mortgages competing for investment dollars as the Fed sells those mortgages it has purchased.  Keep in mind the markets are competing as well with the U.S. Treasury that has been selling about $100 billion dollars in auctions two or three weeks each month.  This is called over-supply in a market.

If you were an investor and had the option to purchase brand new mortgages at say 5.75% in yield or experienced mortgages with proven payment histories for 5.25%, which would you buy?  Or perhaps a nice Federally guaranteed Treasury bill at 3.75% or higher?

Looking ahead I see no reason to revise my prediction of last week that the conforming 30 year fixed rate will climb to or above 5.5% by the end of summer and head to 6% by the end of the year.  Between the lack of demand and over-supply in the bond markets created in the most part by the Federal government entities (the Fed and Treasury), rates have no reason to stay as low as they have been.

Have a question for me?  Ask me!

Special update Earlier this week I sent and email to several real estate agents addressing the ability of homeowners who have gone through a short sale, or will be going through a short sale, to purchase a new home.  The letter and the criteria are on my blog, link here.

Good news for housing markets this week as the Case-Shiller Home Price Index came out showing flat prices between January 2009 and January 2010—with increases in several markets including Los Angeles and San Diego.  The stabilization in housing prices is step one in recovery for the industry and country.

Showing the trend of higher rates the Mortgage Bankers Association’s Weekly Application Survey showed that refinance applications as a portion of all mortgage application have hit their lowest level since the third week of October 2009 (63.2% of all applications).  While still a majority of the applications, as recently as three weeks ago refinances consisted of almost 70% of total applications.  With the double-dipping state and federal tax credit bonus potential for many home buyers in California, plus the news of housing prices starting to firm up and rising interest rates, we should see an increase in buying activity this Spring and possibly Summer. 

Overall the economic news was good this week.  Today the jobs numbers for February were released showing an increase in hirings with 162,000 new employees added to payrolls for the month.  A good portion, about 25%, of the increase was due to the government hiring for the 2010 census, however private non-farm payrolls increased by over 120,000.  While over 140,000 Americans filed first time claims for unemployment insurance, that number has been dropping the last several weeks.  Consumer confidence saw a bump in February and consumer was flat from a year ago, but that is better than a drop. 

As many of you know, positive news is not good news when it comes to interest rates.  Good economic news means economic recovery means higher interest rates as demand for borrowing increases and the Fed move to stave or hold back any inflation above acceptable levels in the 3% ballpark.

Have we seen the bottom of the rate market?  Between the supply and demand equation for bond investors changing, the economy apparently bottoming out and increasing employment numbers all signs point to mortgage rates going up.  We may see some dips in rates ahead, but they will get futher apart and shallower.  If you have been waiting for the bottom of the market you may have waited a few weeks too long—we’ll know in the next several weeks.

Four negative days in a row lead us to a MBS market that closed today (early for Good Friday) at its lowest closing price since December 28^th. 

Rates for Friday March 19, 2010:

FIXED RATE MORTGAGES AT COST OF 1 POINT*

30 year conventional 5.125%                            Up 0.25%

30 year conforming-jumbo 5.25%                     Up 0.125%

30 year FHA    4.875%                                    FLAT

30 year FHA jumbo 5.25%                              Up 0.25%

Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, and period rate is locked (i.e 45 days instead of 30 days).

Please note that rates quoted are based on average of several lenders for a purchase transaction with 20% down payment and a minimum FICO score of 740; APR is not quoted as it is dependent upon specific loan amounts, lenders and services selected.  Numbers provided are for comparative purposes only.

Happy Easter, don’t forget to count your eggs before and after the hunt to make sure the kids find them all!

Have a great weekend everyone, let me know how I can be of service to you.

Dennis